How To Use S&P 500 Futures To Predict Market Movement

Every day, the S&P 500 index opens for trading at 9:30 AM EST and closes at 4:00 PM EST. S&P 500 futures contracts, on the other hand, trade 24 hours a day in different markets all over the world.

If the S&P 500 closes the trading day at 4,000 and the S&P 500 futures are trading at 4,020 the next morning, that creates a spread of 20 points. That does not mean the S&P 500 should open 20 points higher.

Theoretically, owning every stock in the S&P 500 should produce the same return as buying S&P 500 futures contracts and holding until expiration. However, there are two practical differences between the two scenarios.

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First, it would be extremely expensive to buy shares of every single S&P 500 stock. One share of NVR, Inc. NVR at $4,288, one share of Alphabet, Inc GOOGL at $2,304, one share of Amazon.com, Inc AMZN at $2,234, one share of Booking Holdings Inc BKNG at $2,118 and one share of AutoZone, Inc. AZO at $2,025 would run up a tab of $12,969. After those five stocks, there are only 495 more to buy.

Practically, to buy the entire S&P 500, it would likely be necessary to borrow money and pay interest on the borrowed funds. In addition, many of the components of the S&P 500 pay dividends, and S&P futures contracts do not.

Calculating Fair Value

These two differences between the S&P 500 and S&P 500 futures mean that an adjustment must be made to the value of the S&P 500 index price before making a fair, apples-to-apples comparison to the S&P 500 futures. This "adjustment" is called "fair value," and here is the typical formula for calculating it:

FV = S * [1 + (I - D)]

where

FV = fair value
S = the current price of the S&P 500 index
I = the current interest rate to borrow funds to buy the S&P 500 components
D = the current dividend payment rate of the S&P 500 components

When watching Squawk Box before the market opens, the scroll shows the change in the S&P 500 futures and the "fair value" CNBC has calculated.

Imagine the S&P 500 closes on Wednesday at 4,000 exactly, and at the time the market closes the S&P 500 futures are priced at 4,020. Next, imagine that overnight, the S&P futures drop in price by 10 points to 4010. On Thursday morning, CNBC calculates the "fair value" for the S&P 500 futures to be 4,024. The scroll on CNBC's screen will read "S&P500 Fut -10 FV +4"

The -10 comes from the 10-point drop in the price of the futures since the previous day's close, and the +4 comes from the difference between the calculated fair value of the futures (4,024) and the 4,020 price at the previous day's close.

Predicting The Open

The real meat on the bone of this discussion of fair value is that these two numbers can easily be used to determine what CNBC calls the "implied open." If you take the change in the S&P 500 futures (-10) and subtract the fair value (+4), you get an approximation of the change that will likely occur in the actual S&P 500 index immediately after the opening bell.

In this hypothetical scenario, (-10) - (+4) = -14, or a 14-point implied opening drop in the S&P 500.

Original publication: 2014-10-10